How Lloyds Banking Group plc Could Hit 160p!

You must have heard it a million times: the obvious choice for value hunters in this market is Lloyds (LSE: LLOY) (NYSE: LYG.US) — a bank stock that hasn’t been one of my favourite picks for a very long time.

To be honest, I haven’t made up my mind yet, but trends are surely encouraging for its shareholders and should not be overlooked. Similarly, however, other calculations should be taken into account when deciding whether to snap up its shares or not. 

UK Government Stake Sale

I have been sceptical about the speed at which the UK government would have managed to trim its stake in Lloyds — until recently. Latest news has surprised me indeed, just as it did its latest quarterly results.

In late February, the UK government said that it had sold 1% of Lloyds stock, reducing its stake to 23.9%. In less than four months, its holding has now dropped to below 17% of the bank’s equity capital, it emerged on Tuesday. During the period, the shares have risen 12%.

Most of the rise must be attributed to its latest trading update and the outcome of the General Election rather than to the UK government’s strategy, but the good news is that Lloyds may return to full private ownership by the end of the first quarter 2016, well ahead of schedule — and by then, it may even command a premium to its current valuation of 85p a share. 

So, is the tide turning? 

(As a reminder, if you had bought Lloyds in the late spring/summer of 2009, you’d have recorded a pre-tax capital gain very close to zero for the period ending March 2015.)

Lloyds At 160p 

While I think that a big rise in dividends and buybacks may be premature (many analysts would disagree, of course), I’d focus on trailing trends and fundamentals. 

Lloyds traded around 160p a share in September 2008 when Lehman Brothers filed for bankruptcy. 

In 2008, earnings per share (EPS) plunged 39% to 29.7p from 48.6p year on year; its profits halved and returns plunged, according to its annual results, which were released on 27 February 2009 — at that point, Lloyds traded at 37p a share as the full extent of the damage caused by the banking crisis had become apparent. 

Anybody who had invested in Lloyds in early September 2008 would have purchased its stock at around 200p, securing an investment that not only would have generated EPS of 29.7p for the year, but one that paid out its last dividend (11.4p a share, down 70% year on year) until recently.  

How Can You Miss The Opportunity?

Back to these days, and Lloyds is broadly expected to report EPS of 5.3p, 7.4p and 8.3p in 2015, 2016 and 2017, respectively, on the back of rising net profits (from £3.7bn in 2015 to £5.9bn in 2017).

Assuming Lloyds can achieve such an impressive growth rate for its bottom line, you should consider that it would have to shrink its total number of shares outstanding by 70% to around 20 billion of shares outstanding to be able, some 10 years later, to generate rising 2015-2017 EPS of between 18.5p and 29.5p over the next three years (as a reminder, 2008 EPS stood at just below 30p). 

Of course, nobody wanted to hold bank stocks six years ago — but for each penny invested you’d have had a claim on a much higher portion of net earnings in 2008. 

Now, assuming a 10% discount to its current market price, the bank would have to buy back 50bn of its own shares, spending £38bn, or more than £10bn a year, assuming buybacks are held over the next three years, to generate 2017 EPS in line with the level that it recored in 2008. 

For me, the obvious question is: where is the bank going to get that money from, particularly if it aims to raise its payout ratio over time? 

Revenues and net income margin are unlikely to grow at a fast pace, while impairment could spoil the plans of management. 

Most likely, you'd hold a stock whose EPS is rising fast from a very low level, but then you'd be better off choosing the shares of a much smaller, high-growth company, whose fundamentals look rather solid, and whose valuation is much more appealing than that of Lloyds!

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Alessandro Pasetti has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.